Market making and electricity price formation in Japan

• Published in: Energy economics 2022-03, Vol.107, p.105765, Article 105765
• Main Authors: Kanamura, Takashi, Bunn, Derek W.
• Format: Article
• Language: English
• Subjects: Auctions; Electricity; Electricity pricing; Energy economics; Intervention; JEPX; Liquidity; Market-makers; Markets; Prices; Regime switching; Switching; Time series; Trading; Volatility
• ISSN: 0140-9883; 1873-6181
• DOI: 10.1016/j.eneco.2021.105765

Market-making, a common trading practice, is often directed by regulators to improve the liquidity in new products, to make their prices more reliable as markers and to encourage new entrants. Establishing its effectiveness is sometimes elusive, however, as market participation and behaviour can be confounded by many special circumstances, especially in energy. We develop an unusual model-based approach in order to establish if a market-making intervention improved the fundamental price formation dynamics. In the context of the Japanese wholesale electricity auction, we develop a dynamic regime switching formulation to account for the distinct effects of buy-side and sell-side volumes on price formation, using temperature as a regime switching driver. The model has a nonlinear functionality that allows it to fit the spiky time series very effectively. The result is clarity that after a market-making intervention in 2017, the buy and sell volumes had more intuitive and distinct effects upon price formation, compared to previously. In addition, temperature information has been more coherently embedded in price and volatility fundamental modelling since the intervention. We argue that the model indicated a more balanced market with buy and sell side regime drivers behaving more consistently with improved market efficiency. •We model temperature-driven regime switching of buy and sell bids on JEPX prices.•The buy and sell volumes affect price formation after a market-making intervention.•Temperature has been embedded in price and volatility fundamental modelling.•A balanced market with the regime drivers behaves with improved market efficiency.•Fundamental efficiency is a significant indicator that market-making is effective.